262 - An Operational Measure of Riskiness: A Comment

DNB Working Papers
Date 23 September 2010

Foster and Hart (2009) derive a measure of riskiness that relies on linking the choice of any given gamble to a level of critical wealth, below which it becomes risky to accept it.
The authors argue that as this measure depends only on the outcomes and the probabilities (the ‘distribution’), and not on the gamble itself or the decision-maker’s preferences, this measure is ‘objective’. In this paper we will argue that the set-up assumed by Foster and Hart implies a very specific set of preferences on the part of the decision-maker, and that it is therefore not ‘objective’ in the sense intended.
It is argued that the fact that the measure is a tool or rejecting a gamble (not accepting it), as well as the fact that there is an explicit wealth measure that can be made state-contigent, are potentially useful to a social planner. By means of an example, we discuss this in the context of bank regulation.

Keywords: risk, bank regulation.